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Madoff's Investors Face Dim Prospects in Court

By Jane Bryant Quinn
Sunday, February 22, 2009

The securities laws may be your worst enemy if you lost money in the Madoff scam. Investors are suing the feeder funds that channeled their money to Bernard Madoff, accusing the feeders of fraud, negligence or breach of fiduciary duty. On the surface, the cases sound like slam dunks.

They're not. Congress and the courts have spent more than a decade writing and affirming laws that protect companies from irate investors. Those laws may turn out to be feeder fund protection acts.

For investors who lost money, the problems begin with the federal Private Securities Litigation Reform Act (PSLRA), passed in 1995. It was designed to reduce the number of "frivolous" securities lawsuits filed in federal courts. In essence, it says that investors can't proceed with a case unless they already have facts in hand that strongly suggest a deliberate fraud.

By this standard, it's not enough to claim that the feeders failed to investigate Madoff or issued financial statements later found to be false.

You have to show that the feeder probably knew about the fraudulent scheme, or recklessly disregarded evidence of it, or that the fund violated a written commitment -- say, by investing all of your money with a single manager when it specifically promised not to. You need evidence showing that your claim is strong.

The feeders will argue that they didn't know what Madoff was up to, that they vetted him along with other managers and that everyone was fooled. They have a good chance of getting your case dismissed. "Stupid" isn't a triable offense.

Before the PSLRA, you could have started your case with minimal evidence and used pre-trial discovery to search for more. The feeder would have had to turn over e-mails and other documents that might show it had doubts about the Madoff accounts. Today, however, you need such evidence just to begin, and it's tough to get.

You also can't argue that the feeders are liable because their actions made the fraud possible. In 1994, the Supreme Court ruled that investors can't sue advisers -- investment banks, lawyers, accountants -- that aid and abet a securities fraud (the case was Central Bank of Denver v. First Interstate Bank of Denver). Abettors have get-out-of-jail-free cards.

You might get a break if Madoff made secret kickbacks to one or more feeder funds to bring in more cash. No one knows whether that happened. If it did and Madoff confesses to it, that could be enough evidence of fraud to get you into court, said John C. Coffee, a professor of law at Columbia University.

Most securities fraud cases have to be brought in federal court, but there's potentially a second road to justice. Instead of claiming fraud, investors can claim that the feeders breached their fiduciary duty -- a charge that's tried in state courts. It doesn't require proof of fraudulent intent.

"Getting these cases into state courts is crucial for the litigation because success will depend heavily on getting access to the feeder funds' records," said James Cox, professor of law at Duke University.

There's a hitch. Class actions involving the securities laws and covering more than 50 people can easily be moved by the defendant to the inhospitable federal courts. A case can also be moved for other reasons -- for example, if it was filed in a state other than the one where the feeder has its main office.

Many of these cases will wind up in New York, where some of the principal feeders are located. That creates yet another problem. A state law called the Martin Act prevents individuals from filing claims under New York securities laws. Only the attorney general can pursue an action.

You can't even pursue a breach-of-fiduciary-duty claim in New York's courts if the breach involves a securities case. It has to go to the federal courts -- a finding affirmed as recently as July 2007.

In that case, South Cherry Street, an investment group, sued Hennessee Group, a consultant, for recommending the Bayou Group, a hedge-fund Ponzi scheme that blew up in 2005. The judge, Colleen McMahon, also found that, even if Hennessee's principals had egregiously failed to investigate Bayou, they weren't liable for South Cherry's losses as long as they didn't deliberately shut their eyes to what was going on.

Her decision is on appeal, and lawyers are closely watching it. "It's a stark example of how many barriers there are now to private investors seeking to recover," said Joel Laitman, an attorney with Schoengold Sporn Laitman & Lometti in New York.

Investors are pursuing one other set of deep pockets: The institutions chosen by the feeder funds to be custodians of the assets. Custodians are supposed to hold your investments and account for them. Their presence made people feel secure.

Most custodial contracts, however, permit the appointment of subcustodians, says Dominic Hobson, editor in chief of London-based GlobalCustodian, which covers the field. Ideally, the subcustodian should be independent, but the contract may not require it. In this case, the institutions handed off to Madoff, acting as his own custodian.

Custodial contracts typically require that subs be chosen carefully and monitored, Hobson says. An institution might argue, successfully, that it did indeed monitor Madoff but was craftily misled.

This isn't to say that the feeder funds are safe, only that lawsuits face surprising hurdles. Investors whose contracts include an arbitration clause might do better. Arbitrations don't follow the securities laws. At the very least, you'll have a chance to make your case.

Jane Bryant Quinn, author of "Smart and Simple Financial Strategies for Busy People," is a Bloomberg News columnist. Alexis Leondis contributed to this column.

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